What makes a climate risk appetite?

Banks have to assess their stomach for climate change-related threats differently

The ABC’s of risk management start with ‘appetite’. Any chief risk officer (CRO) worth their salt must first define the amount and type of risk their institution is ready to stomach and get board sign-off in a risk appetite statement.

At forward-thinking banks, climate risk is starting to make an appearance in these statements. But their numbers are few. Kevin Stiroh, an executive vice president of the Federal Reserve Bank of New York, said on March 9 that only a handful have “formally modified or qualified enterprise-wide risk appetite statements to acknowledge climate to date.”

In addition, responsibility for calculating, measuring, and dealing with climate risks appears to be dispersed across entities, rather than concentrated in the top echelons of management. As Stiroh explained: “based on our observations, information flows and detailed climate reporting appear more prevalent at the management committee level rather than boards of directors.”

Recent bank reports bear this out. For example, Citi — the only major US bank to have produced a climate risk report — did not include climate risk in a list of major risks covered by its risk appetite statement (though it does acknowledge elsewhere that climate change “presents immediate and long-term risks to Citi and to its clients and customers”).

Then there’s Deutsche Bank, which though it may be working on “approaches to define climate risk appetite”, appears to have spread responsibility for this across the organisation. So while Deutsche’s enterprise risk committee is charged with “the holistic management of climate risks”, the day-to-day handling of climate-related reputational risks and physical risks are dealt with elsewhere.

Certain financial watchdogs are trying to bring things to order. In April last year, the UK’s Prudential Regulation Authority (PRA) laid out climate risk expectations, stating that a firm’s board should have a strong grip on the financial risks from climate change and “be able to address and oversee these risks within the firm’s overall business strategy and risk appetite.” It also wrote that a relevant existing senior management function should be responsible for identifying and managing climate-related risks.

Who’s hungry?

Setting a climate risk appetite, though, is no walk in the park. One problem is that climate risk does not fit neatly into its own silo, like credit, market and operational risks — it cuts across all three.

In addition, while these others risks can be hedged and insured with sophisticated financial instruments, climate risk cannot be offset so simply. Sure, a bank can buy credit default swaps to protect against select counterparty defaults. But it cannot buy insurance on every one of the $1 trillion of assets (and probably much more) at risk from climate impacts.

Furthermore, climate change won’t just inflict cascading financial losses — it threatens to unravel the financial system itself. This makes it tougher to compartmentalise.

Take the word of experts at the Bank for International Settlements (BIS), who say climate events are “green swans” — characterised by deep uncertainty and non-linearity that could shatter the networks through which risk and capital flows around the world.

Because climate risk is different, CROs need to define climate risk appetites differently, too. As a first step, they should recognise their institutions are not just passive objects of climate risk, but that they have an active role to play in lowering the system-wide threat. Sure, banks are financial intermediaries, not investors. But they can decide which investors to extend their services to, and under what conditions.

To set these parameters, a CRO should define specific climate metrics that lead to a responsible and sustainable portfolio of activities. The overarching target should be the limitation of global warming to 2°C above pre-industrial levels by 2050: the goal enshrined in the Paris Agreement. This is a worldwide objective, but can be disaggregated to the company level. Put simply, a bank’s climate risk appetite should not exceed an amount that would cause it to contribute to a plus 2°C warming.  

In fact, banks should aspire to more, as their capital can be leveraged many times over to fund client activities. A bold CRO would dedicate their firm to being a net contributor to the Paris target: taking action to contain warming below 2°C instead of to 2°C.

Get in line

Setting a temperature commitment should be the first line of a climate risk appetite statement. The second should explain how this promise will be kept. One attractive parameter is “temperature alignment”.

David Kelly, co-founder of The Quant Foundry, a UK-based firm working to address climate change modelling, explains:

“If we imagine a budget of how much carbon humanity can emit over the next thirty years to reach the 2°C target, we can disaggregate the tonnage to individual companies. If a company's carbon footprint is higher than the allocation, its temperature alignment score is higher than 2°C.  For most large portfolios of investment, the temperature alignment is around 3.4°C. To amend this, a CRO can in the risk appetite statement set annual targets for temperature alignment across all risk positions.”

The challenge then becomes one of measuring each client’s carbon emissions, and the trajectory of its emissions over the thirty years to 2050. A wild array of metrics have been deployed for this purpose, including the Paris Agreement Climate Transition Assessment (PACTA) and Partnership for Carbon Accounting Financials (PCAF).

Getting tough

The choice of methodology matters, but isn’t core to a climate risk appetite. What matters more is a description of how the temperature commitment and targets will be enforced. Just how can a CRO ensure firm-wide adherence to a temperature limit?

Here’s Kelly’s advice:

“A simple mechanism is for the CRO to introduce a transfer mechanism between those that are planning to retain risk that is above the temperature alignment target to those that are, for example, lending to renewables projects.  In the credit space, the risk team can define a climate change premium to adjust loan repayments, creating incentives for the dealmakers to favour ‘temperature aligned’ projects. The CRO can also embed the climate change premium into individuals’ compensation packages. The advantage of defining a risk appetite statement in this way is that it leverages off existing, well-established and proven risk-based methodologies, which are scientifically neutral and can easily be used to align incentives.”

The details matter, of course. A CRO cannot reallocate employee bonuses so much that they spark a mad rush by dealmakers to sell as many “green” loans as they can, credit risks be damned. Nor should they exempt any one division from the climate risk appetite on the understanding that others will pick up the slack. This would allow a bank-within-a-bank to form, set apart from the incentives and goals of the group as a whole. Bad things happen when such dynamics take root.

Where a climate risk appetite is well-crafted, clear and holistic, all these underlying mechanics should operate effectively within its limits. Where it is not, chaos and confusion can result. It’s therefore critical that CROs get these appetite statements locked down and committed to by the board before setting up climate risk management processes and procedures.

Otherwise the limbs of the organisation are operating without a brain to direct them.

My thanks to David Kelly of The Quant Foundry for his contributions to this article.

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